Volatile Muni Market Taxes Confidence But Not Returns

Jennifer Leigh Parker,|Special to CNBC.com

Tuesday, 14 Dec 2010 | 4:31 PM ETCNBC.com

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The recent selloff in the historically stable municipal bond market may have given investors pause, but investment pros say the intrinsic value of munis remains, especially for tax-conscious investors.

Though a good part of that is now behind the market, the creditworthiness of municipal issuers remains a key consideration going forward.

"Any investor in the muni market is aware that credit issues are more pronounced than normal, but generally it is a high-quality sector," says Ashton Goodfield, head of Muni Bond trading at Deutsche Bank. [With] well known issuers, we are not expecting a big rash of defaults."

How to Navigate The Market

Over the course of the year, munis have become cheaper than Treasuries. Yet, according to Tom McLoughlin, Head of Muni Research at UBS Wealth Management, this is an anomaly.

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"Remember that munis tend to move in sympathy with Treasuries, but not identically. When the time comes for Treasury yields to rise, you can expect munis to rise as well."

Which is exactly what has happened--and what McLoughlin expected—in recent weeks.

In the last 30 days, the 10-year Treasury yield increased 51 basis points to 3.28 percent, while ten-year municipal bond yields moved up by 49 basis points to 3.23 percent. As bond yields rise, their prices fall.

In the recent Treasury market selloff, muni holders were slightly better off. Looking ahead, if you anticipate a greater relative rise in Treasuries yields, stick with the munis.

As a rule of thumb, muni and Treasury yields should be compared on a before tax basis. If you multiply the muni tax-free yield by 100 and divide by your federal tax rate, you’ll get the taxable equivalent yield. [Assuming a 28% federal tax rate, the current 3.23 percent muni yield is equivalent to a taxable yield of 4.49 percent.

There’s more to munis, however, than their relative value to Treasurys. Any investor eyeing the muni market needs to pay more attention than ever to bond type, size and maturity.

Consider The Source

One key difference is general obligation vs. revenue bonds. For the neophytes out there, general obligation bonds pay investors a coupon financed by state tax revenue. Revenue bonds are paid for by a specific entity and are often used for water plants, airports and toll rolls.

More than ever before, small municipalities have started to walk away from their debt obligations. From a post-default standpoint, you are almost always better off with a revenue bond because the earmarked cash flows legally belong to investors. By contrast, General obligation bonds have no dedicated assets behind them.

No surprise then that the issuance of revenue bonds is up 7.9 percent from 2009, according to Securities Industry and Financial Markets Association, SIFMA, data. By contrast, issuance of general obligation munis is down 5.0 percent from 2009.

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McLoughlin says bigger is better.

"Conservative investors should focus on large revenue bonds versus smaller niche plays with less certain revenue forecasts" In other words, Avoid the golf course or steam plant project and go for the bridge or highway.

"The amount of money states spend on servicing muni debt is about 5 percent of their expenditures. That's not very much. Not paying that debt isn't going to help them because it makes it impossible to [finance] capital projects going forward."

McLoughlin agrees: "I do not expect state government's to default. There is definite safety in essential public utilities like water, sewer and municipal electric power."

Seek Low Duration

Duration is a another key consideration.

If you're nervous about inflation post QE2, keep the duration of your bond portfolio low. Duration is a bond's price sensitivity to a change in interest rates.

"If you buy a high quality muni, you're looking at yield to maturities at very low interest rates. If there is any kind of inflation, those yields to call will drop substantially," says Lisa Maurer, SVP of Prosper Advisors. "We keep durations under 4.5 because we are looking to keep volatility low.

A duration of 4.5 means that if interest rates move up 100 basis points (or 1 percent) this portfolio will lose 4.5 percent of its value.

If the duration is 7, and rates went up 100 basis points, the portfolio would lose 7 percent of its value. Thus, keeping the duration under 4.5 keeps the bond portfolio less vulnerable to an increase in interest rates.

"We're suggesting munis with a short-intermediate term duration are going to better withstand market volatility," says McLoughlin, who is also decreasing duration in his portfolio. "Seven to 14 year [maturities] are in the best position, because that part of the curve gives you incremental yield without exposing you to volatility."

Buy In Bulk

The smaller size you trade in the muni market, the wider spread you pay.

"What's generally out there for an individual investor is mispriced," says Goodfield.

Large bond portfolio managers do have an advantage over investors at a retail brokerage. You're paying a much wider spread for anything under $1 million than the mutual fund manager who gets a bargain price by buying blocks of $5 to $10 million.

While the muni market is still a haven for the tax-conscience investor, its new landscape demands close attention.

“It is clear that the old approach of ‘buy ‘em and forget ‘em’ simply won’t work anymore," says Ryan. "Investors need to be just as diligent in evaluating their municipal holding as they are in selecting any other financial asset.”